Unlocking a world of opportunities

In a highly interconnected world, the best investment portfolios will be constructed from the best companies, themes and funds from around the world. However, translating economic views and opportunities into individual portfolios is a challenge when there are so many moving parts and many financial organisations themselves are mammoth.

Each client portfolio will usually be the result of a structured investment process, where the wealth manager’s main views on markets, currencies, regions and risks are discussed and bundled in a holistic view. Most advisers are agreed that a portfolio full of stand-alone decisions will never be able to create robust and sustainable returns. The starting point will usually be the allocation decisions taken by the global investment committee, followed by an engineering and structuring phase, where these views are translated into concrete investments.

However, no system is perfect. Take for instance the global investment committee, which is tasked with discussing and distilling the collective knowledge of the group’s analysts and managers. BNY Mellon Wealth Management uses a system it calls Judgment with Quantitative Discipline to check any such resulting decisions against quant-based valuation models. “Having chaired many investment meetings, it can be dangerous when asset class managers fall in love with their own asset class and so the quant basis is there to ask proper questions,” says Leo Grohowski, chief investment officer at BNY Mellon Wealth Management.

“It is so easy to have a global markets strategy committee where the strongest personality, or the most articulate presenter, influences the outcome. That’s a concern around a purely judgmental process. The same people get together and talk about the same asset class and you get to a point where they can finish each others’ sentences. We like to rotate fresh eyes and ears through our investment committees for six-month periods to guard against ‘Group Think’, taking advantage of the 250 portfolio managers we have here.”

A huge organisation with an army of analysts worldwide can find it hard to harness the depth of expertise, while a slimmer house may be able to implement its view more quickly. “I’ve seen from personal experience the difficulties of regional analyst platforms,” says Tim Heffer, institutional business development at Skagen Funds.

“The communications effort rises fast, especially as it will involve different cultures and different timezones, and what analysts say and how they say it will be very different, with varying degrees of emphasis, so that converting it into a standard message is a real challenge.”

This is exacerbated by the market’s growing propensity to move in extreme and contradictory ways. Volatility is often perceived to be negative but of course it also stands for risk and opportunity, and the ability to deal with it well in the context of portfolio modelling seems likely to drive the best businesses in the next few years.

“There is no disputing that the landscape ahead for investing will be more interconnected and this points to developing diversification with an expanded toolkit,” says Mr Grohowski. “Markets will overreact, creating mis-valuations and opportunities that investors will need to take advantage of,” he adds.

“A broad diversification is especially important in a volatile market environment as we have at the moment,” says Andreas Russenberger, managing director of Credit Suisse in the asset management division, based in Zurich, and co-head of the Global Multi Asset Class Solutions department, which manages over SFr130bn (€100bn) for clients.

“The starting point always has to be the client’s individual asset allocation needs, ensuring an optimal risk/return profile, but there is a natural tendency for clients to have a disproportionate home bias while diversifying a portfolio globally is necessary to help optimise risks.”

Wealth managers say regional bias persists because their clients tend to have greater confidence in local stocks because they think they have better access to relevant information, but this is doubtful. It is a behavioural finance matter. Many are now building portfolios using a series of global managers.

“I have worked with many clients at the distribution houses, private banks and multi-managers and we are seeing a change in the way they are building portfolios, generally building up regional allocations at the expense of the domestic market, usually by using an increasing number of global equity managers,” says Skagen’s Mr Heffer. “There is a much stronger interest in global equity across the wealth management universe, reflecting the changes we see in the institutional pension fund space, where generally they are taking allocations away from domestic managers.

“Global managers have access to a wide range of options and so have a greater opportunity to add value, to be more flexible and to seek value, and of course they are not (as strictly) benchmarked. The MSCI World is less concentrated and distorted than the UK index, without those huge weights to individual stocks or sectors such as banking. We are therefore less likely to see managers hugging the benchmark, and being completely unconstrained is proven to be the best way of gaining alpha for clients.”

The rise of emerging markets continues to be a very important theme, as they account for a substantial part of GDP growth; and global exposure cannot be static – a successful global manager will increase exposure to a region when valuations are attractive and reduce it when they are overvalued.

“We’ve been helping clients to go outside their domestic frontiers and not just geographically, but into new asset classes such as emerging market debt and local market debt,” says Emmanuel Collinet de la Salle, global head of wealth management business development, BNP Paribas Investment Partners.

“Last year we used a greater number of techniques to hedge risk without changing asset allocation by using derivatives and also funds – for example using funds such as Harewood GuardInvest Euro Equity to target a maximum 10 per cent risk. We also optimise portfolios in terms of risk by using Parvest Flexible Equity Europe, which is targeted to achieve an asymmetrical performance linked to European equity markets while controlling volatility. It aims to outperform markets when they are bearish and match their performance when they are bullish.

Such products resonate with clients who have developed a clearer appreciation of risk. While 10 years ago, investors were largely focused on the upside, the new preoccupation with risk seems here to stay, and diversification continues to be seen as a credible strategy.

“A lot of our work over the last two years has been to broaden the toolkit for investors for balanced portfolios,” says BNY Mellon’s Mr Grohowski. “A lot of investors went into the crisis thinking a diversified portfolio of small, large and regionally spread equities was diversified, but correlations have moved very high.

“The diversifiers we think should comprise a balanced portfolio include tips, managed futures, hedge funds, private equity, and absolute return funds,” he explains.

“Three years ago many investors rolled their eyes at diversification speeches, but they are now seeing the value in it. Managed futures (financial futures and commodity futures) are an effective way to get lower correlation – this strategy held up well in 2008 and 2009. Managed futures might be 3-4 per cent of the asset allocation pie for a dollar-based US investor,” says Mr Grohowski.

“Even if you know where fat tails are, you cannot protect the portfolio absolutely from risk, you can only reduce it,” agrees Bjoern Jesch, head of portfolio management at private wealth management, Deutsche Bank in Germany , where he is in charge of €15bn of client funds.

“How to hedge against risk is therefore important. We hedge risk by buying volatility or derivatives, and have developed this in the last two years. Some of the competition is still stuck in the old ways of doing this by buying bonds and balancing the portfolios with overweights and underweights, which is less efficient.”

For many years, derivatives were an instrument that only institutional investors were familiar with, according to Mr Jesch. “However, professional portfolio managers aim to make the potential of institutional instruments accessible for private clients too. Although we still do have the occasional portfolio with restrictions, especially during the last years, most of our German clients have learned that derivatives offer a great variety of opportunities. They are inevitable for portfolio protection and performance enhancement.

“For unconstrained portfolios (wealth preservation plus return above inflation rate) alternatives are now around 14 per cent, including hedge funds and commodities. Germans are not enthusiastic about hedge funds but I am a strong believer that absolute return strategies are crucial for diversification,” he explains. “We therefore use hedge funds using strategies such as macro-driven, CTA and long/short for this purpose.”

Current economic uncertainty has kept the focus firmly on the macro overlay. “A lot of our clients have a good sense of the business cycle and often talk about GDP but they may not relate it to their investments,” says Michael O’Sullivan, head of UK research and global portfolio analysis for Credit Suisse's Private Banking business.

“We have developed a cycle clock – of three and a half to four years, broken down into four main phases – overheating, contraction and so on – as a framework of how assets perform in each phase of the cycle, that clients can understand and that drives strategic and sector asset allocation. We think the cycle clock’s performance has proved remarkably consistent.”